Business interest rates

In the January 2008 Reserve Bank of Australia (RBA)
Bulletin changes were made to business interest rate
statistics. These changes impact on a regular statistic published
in the Parliamentary Library’s Monthly Statistical
Bulletin.

This feature article explains the
changed methods, results and how the Monthly Statistical Bulletin
will report business interest rates from this edition.

Different
methodologies

Historically, the RBA has published
the ‘large business variable indicator rate’. This
interest rate has traditionally been referred to as the
‘prime rate’. The prime rate is reflective of how much
creditworthy large businesses could expect to pay for loans from
banks. The statistic published by the RBA was the average prime
rate available within a reporting period—usually one
month.

In the January RBA Bulletin,
the prime rate was ceased in favour of a ‘weighted average
interest rate on credit outstanding’. The reason the RBA
changed the statistic is that ‘the large business variable
indicator rate … is no longer representative of large
businesses’ funding costs’. The new interest rate is
reflective of the cost of servicing loans, on all debt
outstanding.

The simple difference between the
rates is that the prime rate records a rate available today for
new debt, while the weighted rate covers actual debt
servicing interest costs on existing debt.

Calculation of weighted
interest rate

To generate the weighted rate, the
RBA sorts each outstanding business loan according to the size of
the loan—to determine business size—and the rate at
which the loan is priced. The number of loans at an interest rate
is then used to calculate a weight to apply to that interest rate.
This is done for all interest rates to calculate a weighted average
rate. Algebraically, the calculation of the rate is:

Where Li is the number of
loans with interest rate ri and L is the total number of
loans. The sum (S) of all such relationships gives a weighted
average interest rate.

Difference in results and
interpretation

The change in series means the prime
rate is quite different to the weighted rate, because of the range
of business debts at different rates, expiring at different points
in the future.

Graph 1 shows the distribution of
large business loans by interest rate used in the RBA’s
calculation. This graph shows the majority of outstanding loans to
large business are priced between 6.5 and 8.5 per cent.

For these data, business size is
determined by loan size. Large businesses have loans of $2 million
or more.

Graph 2 demonstrates the difference
in the rates in practice, by plotting the prime rate and large
business weighted average rate data from December 1978 until
November 2007.

Graph 1. September 2007
distribution of large business interest rates

Until December 1993 there is no
difference in the data recorded by the RBA. From December 1993
until the most recent results, there is a clear divergence between
the prime and the weighted rates. The weighted rate has been lower
than the prime rate because of the perseverance of cheaper credit
products, compared to higher interest rates on new borrowings in
the current market place. As cheaper credit products expire and
higher cost credit becomes prevalent, it is likely the weighted
rate will increase.

Graph 2. Prime rate compared to the large business
weighted rate

Monthly Statistical Bulletin
Table 5.1

As a consequence of the change, Table
5.1 in the Monthly Statistical Bulletin will report a large
business weighted average rate rather than the prime rate. The real
prime rate has also been dropped in preference to the similarly
constructed weighted rate for small businesses. Small businesses
are defined as those with loans less than $2 million.